Ups and Downs of 'Equity-Index' Annuities

Updated Sept. 14, 2008 12:01 a.m. ET

Equity indexed annuities are marketed as investments for good economic times and bad. But investors should ask: Is the protection you get in bad times worth the sometimes substantial gains you forfeit in good times?

Last month, this column looked at how new federal oversight could shine more sunlight on these complicated and controversial investments. Critics of the plans say they are often unsuitable for older, unsophisticated investors, who are frequently targeted by sales people. But fans of indexed annuities -- including several readers of our Aug. 17 column -- say the protection the annuities offer when stocks slump (as they have this year) proves their value.

So, are they worth it? It's a challenge to know for sure because there's no comprehensive or standardized reporting of returns and many have only been around for a short time. A sampling of returns provided by annuity issuers and industry sources shows that indexed annuities are holding their value during the current bear market. But the numbers also show that investors can give up substantial gains when stocks are rising.

Limiting Losses

To review: Equity indexed annuities are insurance products. Their returns are tied to the performance of stock indexes such as the Standard & Poor's 500-stock index. Last year alone, investors poured $25 billion into indexed annuities. The attraction is clear: a guarantee provided by insurers that investors will get their original investment back -- even if the index to which the annuity is linked declines.

(There are surrender charges and other penalties if an investor withdraws early.)

That protection, though, comes at a price: Indexed annuities have pre-set caps that limit their gains. And therein lies the dilemma for investors. Stocks historically have returned roughly 10% a year. While stocks can lose value in any given short-term period, putting money in an indexed annuity could mean giving up some of those historical gains.

The mechanics of crediting interest based on the index returns can be complicated. Some products simply measure the change in the index from one point in time to another, known as "point to point," while others use convoluted monthly averaging formulas.

Insurance companies, of course, keep some of the gains for themselves -- such as through monthly or annual caps on the gains and "participation rates," which give an investor, say, 75% of the index return. These limits generally can also be changed on existing annuities, typically once a year.

The formulas can lead to wide variations in performance compared to the stock market -- and the annuities can look like stars or laggards depending on the market environment.

For instance, a February 2003 purchase of Life of the Southwest's Platinum Indexed Annuity would have returned an average of 5.4% a year through February of this year, 2.5 percentage points less than the S&P 500. The reason: The investment, in large part, was "capped out" of huge gains as the last bear market ended.

But that annuity bought just six months later, in August 2003, would have returned 7.3% a year over the five years through last month -- more than double the S&P 500. A key reason: while the S&P is down by double digits in 2008, an annuity holder would get credited zero interest.

'Zero' is a Lot

Such a "zero" -- instead of a big short-term loss -- can have a big impact. For example, an investor who on Sept. 7, 2004, put $100,000 into the Allianz MasterDex 5 Annuity would have had an investment worth $127,917 in September 2007. A comparable investment in the S&P 500 would have been worth $132,769. However, a year later the S&P investment would have fallen to $111,555 -- but the annuity would still be worth $127,917.

Allianz executives note that following a down market, annuity holders get the benefit of any rebound without having suffered the losses. In contrast, says Eric Thomes, a senior vice president at Allianz, "if you were just invested in the market, you would have to get all the way back up to even before you start recognizing gains."

Broader Sample

Last year, a once-a-year sampling of performance data collected by Index Compendium, an industry newsletter, showed how far behind indexed annuities lagged during good times. As of September 2007, the survey of 20 indexed annuities found a half-dozen credited interest between 7% and 8% a year over the previous five years and the rest between 5% and 6%. Meanwhile, the S&P 500 rose an average 13.4% a year during that time frame.

Given the stock market's performance over the past year, however, the 2008 version of that survey is likely to show a more impressive comparative performance by the annuities.

Diane Carlson, age 59, a retired school teacher, says she still isn't sure whether her purchase of an indexed annuity in February 2005 was the right decision.

Through the end of January -- when she received her last statement -- the value of the annuity had risen 17%, including the 10% "bonus" she received at the start of the annuity contract. Meanwhile, the indexes that the annuity tracked gained anywhere from 14% to 24%.

She knows that she will benefit this year from avoiding losses in the market. But she also notes that her annuity carries surrender charges that limit access to her money -- for 15 years.

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